Interview with Nobel Laureate

Nobel Prize winners say markets are irrational, yet efficient

S A Aiyar in The Times of India

Are stock markets irrational, driven by greed and fear, subject to euphoria and panic? Or are they highly efficient indicators of intrinsic value? Both, says the Nobel Prize Comittee for Economics, with no sense of contradiction.

It has just awarded the prize jointly to economists with opposing views. Robert Shiller is famous for two versions of his book 'Irrational Exuberance'. The first version appeared in 2000 at the height of the dotcom boom, and correctly predicted that this was a bubble about to burst. The second version came in 2005 just as the housing market was skyrocketing, and predicted (again correctly) that this too was a bubble likely to burst resoundingly.

This confirmed Shiller's status as a behavioural economist. Such economists laugh at the notion that human beings are rational economic actors, as portrayed in textbooks. No, say behaviourists, humans are driven by fads, prejudices, manias, and irrational bouts of optimism and pessimism. Yet Shiller is going to share the Nobel Prize with Eugene Fama, famous for his "efficient markets hypothesis." This states that markets are like computers processing information from millions of sources on millions of economic actors, and hence produce more efficient long-run valuations than the most talented genius.

Fama's market behaviour is fundamentally random, so future trends cannot be predicted by even the cleverest investors. He implies that choosing stocks by throwing darts at a stock market chart can beat the recommendations of top experts. This has been verified by some, though not all, dartthrowing contests.

Corollary: ordinary investors must not pay high fees to experts to pick winners. Instead they should invest passively in a group of shares (like the 30 shares constituting the Bombay Sensex or Dow Jones Industrial Average), and ride these bandwagons without paying any fees. This has led to the spectacularly successful emergence of Index-traded funds (like those run by Vanguard in the US). Such funds are indexed to share groups like the Sensex or the Banks Nifty. Rather than try to pick individual winners in say the auto, pharma or realty sectors, index funds invest passively in a group of auto, pharma or realty companies. This has proved successful and popular.

Two groups criticize the efficient markets hypothesis: big investment gurus and, paradoxically, leftists viewing financial markets as instruments of the devil. Investment gurus like Warren Buffett in the US or Rakesh Jhunjhunwala in India claim to have beaten the market average handsomely, thus disproving the efficient markets hypothesis. Not so says Fama: in any large collection of investors there will always be some who perform above average and some below average - this is a matter of statistical chance, not skill. Moreover, investment gurus have so many contacts that they may have insider information enabling them to beat the market by unfair means.

As for Shiller's successful predictions, Fama says capitalism is driven by booms and busts. To predict at the height of a boom (like Shiller) that a bust will follow is banality, not genius. It is as unremarkable to predict during every bust that a boom will follow.

After the 2008 global financial crisis, the new conventional wisdom is that governments need macro prudential policies to check future financial crises, and that finance should be more strictly regulated than ever before. However, the counter is that the financial crisis occurred even though the financial sector was already the most regulated (with 12,000 regulators in the US alone). Governments had encouraged reckless lending by guaranteeing large banks and investment banks against failure, and by creating governmentbacked underwriters like Fannie Mae who shouldered any burdens caused by mass default.

Perhaps the Nobel Prize Committee is right in implying that markets can be both irrational and efficient at the same time. Since humans are irrational, they will always create markets that have booms and busts, marked by irrational optimism and pessimism. An efficient markets defined by Fama and his followers is not one that produces steady growth without booms, busts or crises. It is efficient only in the limited sense that, whether the markets are calm or irrational, they represent the processed information of millions of actions of millions of actors, and this is inherently more efficient than the efforts of any individual investor.

The argument is analogous to the one against communism or dictatorship. Communists believed that the great and good politburo, motivated entirely by the public interest and not profit, would run the economy better than the chaos, irrationality and imperfections of the capitalist market. Yet the market, with all its flaws and irrationality, proved infinitely more efficient.

Fama holds that this is true of financial markets too. This is compatible with Shiller's analysis. Markets can be both irrational and efficient.

The maths formula linked to the financial crash

Black-Scholes: The maths formula linked to the financial crash

By Tim Harford BBC Radio 4, More or Less
 

It's not every day that someone writes down an equation that ends up changing the world. But it does happen sometimes, and the world doesn't always change for the better. It has been argued that one formula known as Black-Scholes, along with its descendants, helped to blow up the financial world.

Black-Scholes was first written down in the early 1970s but its story starts earlier than that, in the Dojima Rice Exchange in 17th Century Japan where futures contracts were written for rice traders. A simple futures contract says that I will agree to buy rice from you in one year's time, at a price that we agree right now.

By the 20th Century the Chicago Board of Trade was providing a marketplace for traders to deal not only in futures but in options contracts. An example of an option is a contract where we agree that I can buy rice from you at any time over the next year, at a price that we agree right now - but I don't have to if I don't want to.

You can imagine why this kind of contract might be useful. If I am running a big chain of hamburger restaurants, but I don't know how much beef I'll need to buy next year, and I am nervous that the price of beef might rise, well - all I need is to buy some options on beef.

But then that leads to a very ticklish problem. How much should I be paying for those beef options? What are they worth? And that's where this world-changing equation, the Black-Scholes formula, can help.

"The problem it's trying to solve is to define the value of the right, but not the obligation, to buy a particular asset at a specified price, within or at the end of a specified time period," says Professor Myron Scholes, professor of finance at the Stanford University Graduate School of Business and - of course - co-inventor of the Black-Scholes formula.

The young Scholes was fascinated by finance. As a teenager, he persuaded his mother to set up an account so that he could trade on the stock market. One of the amazing things about Scholes is that throughout his time as an undergraduate and then a doctoral student, he was half-blind. And so, he says, he got very good at listening and at thinking.

When he was 26, an operation largely restored his sight. The next year, he became an assistant professor at MIT, and it was there that he stumbled upon the option-pricing puzzle.

One part of the puzzle was this question of risk: the value of an option to buy beef at a price of - say - $2 (£1.23) a kilogram presumably depends on what the price of beef is, and how the price of beef is moving around.

But the connection between the price of beef and the value of the beef option doesn't vary in a straightforward way - it depends how likely the option is to actually be used. That in turn depends on the option price and the beef price. All the variables seem to be tangled up in an impenetrable way.
Scholes worked on the problem with his colleague, Fischer Black, and figured out that if I own just the right portfolio of beef, plus options to buy and sell beef, I have a delicious and totally risk-free portfolio. Since I already know the price of beef and the price of risk-free assets, by looking at the difference between them I can work out the price of these beef options. That's the basic idea. The details are hugely complicated.

"It might have taken us a year, a year and a half to be able to solve and get the simple Black-Scholes formula," says Scholes. "But we had the actual underlying dynamics way before."

The Black-Scholes method turned out to be a way not only to calculate value of options but all kinds of other financial assets. "We were like kids in a candy story in the sense that we described options everywhere, options were embedded in everything that we did in life," says Scholes.

But Black and Scholes weren't the only kids in the candy store, says Ian Stewart, whose book argues that Black-Scholes was a dangerous invention.

"What the equation did was give everyone the confidence to trade options and very quickly, much more complicated financial options known as derivatives," he says.

Scholes thought his equation would be useful. He didn't expect it to transform the face of finance. But it quickly became obvious that it would.

"About the time we had published this article, that's 1973, simultaneously or approximately a month thereafter, the Chicago Board Options Exchange started to trade call options on 16 stocks," he recalls.
Scholes had just moved to the University of Chicago. He and his colleagues had already been teaching the Black-Scholes formula and methodology to students for several years.

"There were many young traders who either had taken courses at MIT or Chicago in using the option pricing technology. On the other hand, there was a group of traders who had only intuition and previous experience. And in a very short period of time, the intuitive players were essentially eliminated by the more systematic players who had this pricing technology."

That was just the beginning.

"By 2007 the trade in derivatives worldwide was one quadrillion (thousand million million) US dollars - this is 10 times the total production of goods on the planet over its entire history," says Stewart. "OK, we're talking about the totals in a two-way trade, people are buying and people are selling and you're adding it all up as if it doesn't cancel out, but it was a huge trade."

The Black-Scholes formula had passed the market test. But as banks and hedge funds relied more and more on their equations, they became more and more vulnerable to mistakes or over-simplifications in the mathematics.

"The equation is based on the idea that big movements are actually very, very rare. The problem is that real markets have these big changes much more often that this model predicts," says Stewart. "And the other problem is that everyone's following the same mathematical principles, so they're all going to get the same answer."

Now these were known problems. What was not clear was whether the problems were small enough to ignore, or well enough understood to fix. And then in the late 1990s, two remarkable things happened.

"The inventors got the Nobel Prize for Economics," says Stewart. "I would argue they thoroughly deserved to get it."

Fischer Black died young, in 1995. When in 1997 Scholes won the Nobel memorial prize, he shared it not with Black but with Robert Merton, another option-pricing expert.

Scholes' work had inspired a generation of mathematical wizards on Wall Street, and by this stage both he and Merton were players in the world of finance, as partners of a hedge fund called Long-Term Capital Management.

"The whole idea of this company was that it was going to base its trading on mathematical principles such as the Black-Scholes equation. And it actually was amazingly successful to begin with," says Stewart. "It was outperforming the traditional companies quite noticeably and everything looked great."

But it didn't end well. Long-Term Capital Management ran into, among other things, the Russian financial crisis. The firm lost $4bn (£2.5bn) in the course of six weeks. It was bailed out by a consortium of banks which had been assembled by the Federal Reserve. And - at the time - it was a very big story indeed. This was all happening in August and September of 1998, less than a year after Scholes had been awarded his Nobel prize.

Stewart says the lessons from Long-Term Capital Management were obvious. "It showed the danger of this kind of algorithmically-based trading if you don't keep an eye on some of the indicators that the more conventional people would use," he says. "They [Long-Term Capital Management] were committed, pretty much, to just ploughing ahead with the system they had. And it went wrong."

Scholes says that's not what happened at all. "It had nothing to do with equations and nothing to do with models," he says. "I was not running the firm, let me be very clear about that. There was not an ability to withstand the shock that occurred in the market in the summer and fall of late 1998. So it was just a matter of risk-taking. It wasn't a matter of modelling."

This is something people were still arguing about a decade later. Was the collapse of Long-Term Capital Management an indictment of mathematical approaches to finance or, as Scholes says, was it simply a case of traders taking too much risk against the better judgement of the mathematical experts?

Ten years after the Long-Term Capital Management bail-out, Lehman Brothers collapsed. And the debate over Black-Scholes and LTCM is now a broader debate over the role of mathematical equations in finance.

Ian Stewart claims that the Black-Scholes equation changed the world. Does he really believe that mathematics caused the financial crisis?

"It was abuse of their equation that caused trouble, and I don't think you can blame the inventors of an equation if somebody else comes along and uses it badly," he says.

"And it wasn't just that equation. It was a whole generation of other mathematical models and all sorts of other techniques that followed on its heels. But it was one of the major discoveries that opened the door to all this."

Black-Scholes changed the culture of Wall Street, from a place where people traded based on common sense, experience and intuition, to a place where the computer said yes or no.

But is it really fair to blame Black-Scholes for what followed it? "The Black-Scholes technology has very specific rules and requirements," says Scholes. "That technology attracted or caused investment banks to hire people who had quantitative or mathematical skills. I accept that. They then developed products or technologies of their own."

Not all of those subsequent technologies, says Scholes, were good enough. "[Some] had assumptions that were wrong, or they used data incorrectly to calibrate their models, or people who used [the] models didn't know how to use them."

Scholes argues there is no going back. "The fundamental issue is that quantitative technologies in finance will survive, and will grow, and will continue to evolve over time," he says.

But for Ian Stewart, the story of Black-Scholes - and of Long-Term Capital Management - is a kind of morality tale. "It's very tempting to see the financial crisis and various things which led up to it as sort of the classic Greek tragedy of hubris begets nemesis," he says.

"You try to fly, you fly too close to the sun, the wax holding your wings on melts and you fall down to the ground. My personal view is that it's not just tempting to do that but there is actually a certain amount of truth in that way of thinking. I think the bankers' hubris did indeed beget nemesis. But the big problem is that it wasn't the bankers on whom the nemesis descended - it was the rest of us."

Additional reporting by Richard Knight

The Nobel prize for economics may need its own bailout

 

 

Facing a similar crisis of legitimacy, the prize needs to prove it is much more than an award for stockmarket speculators.

• Jayati Ghosh
• guardian.co.uk, Thursday 8 October 2009 22.00 BST

 

The economics award is usually the last of the Nobel prizes to be announced. Correctly so, for it was also the last to be created – and strictly speaking is not even a real Nobel prize. The five original awards, first given out in 1901 for literature, peace, medicine/physiology, physics and chemistry, were intended by Alfred Nobel to recognise contributions that enhanced the quality of human life, through scientific advance, literary creativity or efforts at bringing about peace.

 

The economics prize is not a prize of the Nobel Foundation; rather, it was created in 1968 by the Central Bank of Sweden as a "prize in economic sciences in memory of Alfred Nobel". However, it now has the same procedure of selection by the Swedish Academy, and the same cash award presented at a similar ceremony as the Nobel prizes.

 
There have been recurrent doubts about whether it conforms to the basic goals of the prizes as envisaged by the founder. Is economics a science, on the same lines as physics or chemistry? Does it unambiguously contribute to human wellbeing, like peace or literature? In any case, should economics be privileged over other branches of learning?
 
Peter Nobel, great-grandnephew of the founder and human rights activist, famously argued that Alfred Nobel would not have approved of such a prize, which he termed "a PR coup by economists to improve their reputation ... most often awarded to stockmarket speculators".

 

Certainly the reputation of economists has needed building up, not only in the wake of the global financial crisis, but even before that. As much of mainstream economics became obsessed with navel-gazing esoteric models or theories designed to justify market liberalism, the public became relatively more alienated from the activities of economists. In such a context, the Nobel prize has been a useful tool not only to proclaim the conceptual advances supposedly made by "the dismal science" but also to encourage certain types of economic analysis and research. So its power extends beyond public recognition, altering the very production of economic knowledge.

 
The early prizes generally honoured economists whose work was already widely recognised. But even in the first decade, the list of exceptions was probably more impressive than that of the recipients, as greats like Michal Kalecki, Joan Robinson, Richard Kahn, Nicholas Kaldor and Piero Sraffa were overlooked in favour of lesser contributors. In the subsequent period, the award has occasionally gone to economists of relatively minor and sometimes absolutely questionable achievement, whom others in the profession quickly had to look up when the announcement was made.
 
The political effect of the prize in the profession has been undeniable. There has been overwhelming domination of neoclassical economics, to the exclusion of alternative streams of thought, with only a few nods in the direction of broader and more socially embracing approaches. This has encouraged more conservative approaches in research and teaching.

 

Monetarist and free market approaches have been disproportionately rewarded, often at crucial times. For example, the 1974 award to Friedrich von Hayek led to a resurgence of interest in the Austrian school and made his book The Road to Serfdom a bestseller. Two years later the prize went to Milton Friedman, making his extreme form of monetarism academically respectable and even leading to a conservative policy revolution. Economic history in the turgid and restricting form of retrospective econometrics was promoted by the 1993 award to Robert Fogel and Douglass North, while rational expectations theory was given a big boost by honouring Robert Lucas in 1995.

 

The geographical distribution of the award both creates and reflects power hierarchies in the discipline. The economics prize has been awarded 40 times to 62 recipients, 42 of whom have been from the US, while more than 50 were working in the US at the time of the award. The University of Chicago has 11 laureates, leading to the joke about "the Stockholm-Chicago Express". This does not reflect the actual state of economic knowledge so much as the biases and blindness of the jury. Only two people from developing countries have received it (Arthur Lewis and Amartya Sen) and both worked in the US and Britain. Only three with an interest in the economics of developing countries – which is the economic reality for around three quarters of the world's population – have received the award.

 

In recent years the prize has been focused on financial market behaviour. In 1997, the award went to two economists – Robert Merton and Myron Scholes – who were supposed to have discovered a method of valuing derivatives that could reduce or eliminate risk in financial investment. When the hedge fund they ran (Long Term Capital Management) went bust within the year and had to be rescued by the US federal reserve, there was some embarrassment. Perhaps to right this wrong, a few years later the prize was given to economists George Akerlof and Joseph Stiglitz, who had pointed to the imperfect functioning of financial markets. The award last year to Paul Krugman may also have indicated some bowing to changing times.

 
So far, no woman has received the economics Nobel. Apart from obvious exclusions such as Joan Robinson, this also reflects power hierarchies within the subject, because women economists even in the US and UK tend to be concentrated in the lower reaches of the academics profession, as researchers and lecturers rather than professors.
 
These imbalances will not be rectified easily. But the Nobel prize in economics may now be as much in need of wider legitimacy as the economics profession itself. It will be interesting to see if this is reflected on Monday, when the current year's winner is announced.

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